Western Banks And China: "Interesting Times" Are Coming

We recently cited the work of Sean Darby, equity strategist at Jefferies, regarding the exposure of Hong Kong banks to the Mainland (see: “How Dangerous is China's Credit Bubble for the World” for details). Although Hong Kong is technically part of China, it is a foreign country in terms of its economic system and currency, and should therefore be regarded as a foreign creditor. In fact, the incentives that mainly influence the business decisions of Hong Kong's banks include the US Federal Reserve's monetary policy as a very important factor, due to the fact that the Hong Kong dollar is pegged to the US dollar via a currency board.

Mr. Darby has in the meantime continued to dig into topic of foreign bank exposure to the Mainland, and has recently released his latest findings. Here is a Bloomberg chart that shows how these claims have grown since 2005:

Foreign participation in China's credit boom: note the involvement of French and Australian banks specifically – click to enlarge.

The numbers are as follows at present (the percentage change is since Q1 2011, indicated by the vertical line on the chart above).

Country

% change

Total in US$ 3Q13

Germany

+66%

32bn

France

+60%

41bn

UK

+70%

193bn

Total Europe

+70%

329bn

Australia

+230%

31bn

US

+18%

83bn

The total exposure of Western banks thus amounts to $709 billion. Australia's banks were a bit late to the game, but sure did their best to catch up quickly, as the 230% increase in their claims since 2011 shows.

Aussie Bank CDS has yet to reflect this...

In other words, we now have additional evidence of the growing vulnerability of Australia specifically. As we already pointed out in our musings about how “financial contagion” might spread from China in spite of its closed capital account, Australia is a pivotal region. Australia's economy greatly depends on China's commodity imports, and its banks have financed an enormous real estate bubble on the back of the commodities boom.

Moreover, Australia's banking system itself is highly dependent on foreign short term funding sources. Although the chart above doesn't tell us anything about the maturities of the claims on China, we would not be surprised if many or even most of the loans to China had much longer maturities than the foreign funding Australian banks get from (mainly) Europe. The main point is though that we have yet another source of potential trouble for Australia here – the exposure of Australian banks to China amounts to 9% of Australia's GDP at this point.

Lured by High Spreads, Interesting Times Await

As Mr. Darby points out, the amounts have grown quite large in absolute terms. Banks have evidently been lured by the higher spreads they can earn on loans to Chinese customers, and in large part this is due to the ZIRP policies pursued by major Western central banks. However, higher spreads usually obviously imply higher risk. Adding Hong Kong's exposure to the above numbers, we arrive at about $860 billion in total foreign exposure (ex-Japan we might add).

In the course of this year, some $800bn. of debt issued by 'wealth management products' is coming due in China, and Mr. Darby notes in this context that the potential knock-on effects on Western banks from an increase in non-performing loans in China are probably not properly appreciated at this juncture.

Especially UK banks with a huge $193 bn. in total exposure, as well as Hong Kong banks (approximately $150 bn. in net claims) and Australia's 'big four' banks seem to be in the line of fire here.

Moreover, we must expect that in the event of a shadow banking crisis in China – a highly probable event given what is known about the practices of the sector and the amount of debt coming due in the near future – will have considerable effects on numerous emerging market economies, especially if China should eventually decide to devalue the yuan (currently the yuan seems quite overvalued actually). In that event, both commodity exporters and exporters of semi-finished and final goods that compete with China would feel the pinch.

This would in turn mean that Western banks would not only have to grapple with a possible rise of NPLs in China itself, but also with an even bigger currency and debt crisis in a number of emerging markets. Since many Western banks remain in weak condition following the 2008 crisis and the euro area debt crisis, they will then be inclined to further reduce their lending in their home countries as well, so as to preserve capital. A vicious cycle could easily be triggered.

Sentix sentiment indicator on European bank stocks storms to a record bullish consensus in late January – click to enlarge.

Conclusion:

There is a very good chance that the crisis that began in 2008 is actually not over by any stretch – it is merely moving from one place to the next. After all, the developments discussed above are a direct result of the reaction of the world's monetary authorities to the initial crisis. China's credit bubble and ZIRP in the US and Europe are all children of the crisis and have evidently sown the seeds for the next crisis. As we always stress, we expect that the next major crisis will eventually lead to a crisis of confidence in said monetary authorities. At some point, faith in central banks is bound to crumble and then we will really experience 'interesting times'.

All I know is the local BMW dealership is full of Mainland Chinese Yutes, and an occassional Nigerian, laying down $65k+ ... for new BMWs. Salesperson said it's again their policy to ask where they got the moolaah.

Western banks getting drubbed by the dominoes in China is one more reason (excuse) for the EU & US to confiscate savings and pensions. China would be be the perfect and convenient scapegoat for all the Wests' problems.

I used to live in Aussie for some years back.They negotiated a huge NatGas contract for the Northwest shelf,practically giving the gas away for free to China on a twenty year contract.Now if that gas had been used to switch over the Japanese electric grid from nuke to NatGas......Oh nevermind......

Oh, the nasty web we weave. This is why The Austrian School of Economics is so superior to London, Chicago, MIT, Princeton.... You must let the cookie crumble so the Phoenix can rise. In fact, the cookie will crumble as the Central Banks can only kick the time down the road.

Oh my God, did everyone see the deer-in-the-headlight Yellen? This is why the USA stock market rose this week. In fact, so bad I must remain focused on her side-kick....

Bubbles are growing nicely, the mecanisms of transmission are in place, we are now waiting for the black swan but where will it come from? It cannot be a bank bankrupcy, central banks won't let it happen this time. The weather is strange but it's all localized for now so not enough to have a global impact. But when the "perfect storm" comes, it will be spectacular. Each and every market is primed. +3% of VAT will impact Japan in April, the Euro should have another bout of fever in the Spring, by then the taper should have starved the BRIC's markets of funding. Give it another couple of months and by the Summer the stew should be ready, we'll be in recession officially. To keep the fiction that banks are solvant will then become more and more difficult and not just in China!

If the drought in California continues, combine that with the historically low number of cattle in the country and watch what that does to food prices this spring and summer. Who knows whether it will be enough to crack the system, but as we push onwards and more and more stresses appear, the black swan may turn out to be a straw that broke the camel's back.

I think that we're going to find out just how bad of an idea globalization is in the next year or two.

Of course the exposure is epic. I'm laughing at the gold price rising right now. Go ahead, cheer it on all you want. If it cracks 1380 inside the month it becomes an insurance event and us banks are on the hook for something around $70b or so based on what's currently out there from the big 4 and major privates.

Don't fool yourselves. NOBODY has confidence in the so called financial authorities and if there was a way to have a reasonable (doesn't have to be great or infinite growth) lifestyle without the financial authorities people would jump at it.

didn't JPM upgrade Chines Banks last week setting off the huge rise in the HongKong markets just as it seemed everythig was about to rollover...then came the worldwide ramp from hell and a 100 point S&P rally?